Big Banks Are Still Bad Bets

05/28/2012 7:30 am EST

Focus: STOCKS

Even after all the help the Federal Reserve has doled out to save the mega-banks, they're still wallowing in sins of the past, which makes their future cloudy at best, observes Michael Delman of Cabot Wealth Advisory.

The May 10 trading loss of more than $2 billion by JPMorgan Chase (JPM) has sparked a bevy of news reports.

With good reason too—it’s a massive loss from a bank that many have seen as a “safe haven” for the past few years. JPMorgan came out of the 2008 financial crisis with a surplus of money, and to now see something like this happen is making a lot of people wonder just how much bankers have really changed.

In doing some background reading on the trading loss, I found a fascinating explanation—on American Public Media’s Marketplace Web site—of what exactly happened with the trader known as the London Whale, and how that $2 billion (or more) could’ve been lost.

To sum up, the trader was using derivatives to bet that certain investment-grade bonds would never, ever default. This was used as a “hedge” against losses, but backfired in spectacular fashion because of a combination of factors. The first of those being the trader’s supreme overconfidence in how smart he was, and the second being that rival traders bought up credit-default swaps that were then leveraged against him.

The end result of this is that when the corporate bonds were marked down, the London Whale had painted himself into a corner and couldn’t cover his losses.

And this is how JPMorgan, a company known for its apparently good risk management, showed that they really weren’t that good at it after all. It has also added new scrutiny to the banking sector, which has already been battling increased regulation since the 2008 financial crisis.

Predictably, JPMorgan CEO Jamie Dimon said this was a simple mistake, and the company will learn from it and move on. He didn’t say they’d never use derivatives as a hedge again...just that they’d learn from this mistake.

The loss resulted in an $18 billion drop in JPMorgan’s market cap during the trading day on May 11, and then last week a quick search revealed four law firms filing securities class-action lawsuits against JPMorgan. The US Department of Justice is also investigating the trading loss.

But all that is just background to my real argument today: It’s not a good idea to invest in the banking sector right now.

This is true for several reasons, not least of which is that it’s difficult at best to figure out how some of these banks make a profit. Back when I worked for Nasdaq, I routinely processed corporate earnings statements that public companies filed as part of their Securities and Exchange Commission disclosure requirements.

Banks had the most inscrutable earnings statements by far. At least with a pharmaceutical company, you could tell that their biggest expense was R&D, and they made money when drugs were approved. With banks, I found it near impossible to tell where and how they made any sort of income.

This whole debacle with JPMorgan just underscores that same inscrutable nature of bank profits. If you can’t figure out how a company makes its money, then you probably shouldn’t invest in it. Mostly because if you don’t know how profits are made, then you never know when that money is suddenly going to disappear.

The second, and perhaps more salient point for the current market, is that bank stocks are in a decline. Prior to the crash in 2008, bank stocks enjoyed a massive run due to deregulation and a host of other benefits given in the last years of the 1990s. Since that crash, however, investors have tended to stay away from large, multinational banks...with good reason.

JPMorgan lost $18 billion of its market cap overnight because of that trading loss. Investors who didn’t sell once trading opened on May 11 could’ve lost a few thousand dollars depending on their position size. And this loss completely ignores the fact that other big banks, such as Bank of America (BAC) and CitiGroup (C), are in a persistent downtrend.

For investors interested in growth and seeing their stocks go up quickly, it’s almost a no-brainer to leave banking stocks behind. Bank of America hasn’t traded above $10 in more than a year, and CitiGroup has declined 36% in roughly the same time frame. For a look at the broader market, the Financial Select Sector SPDR ETF (XLF) has been range-bound around $15 for the past two years (this is after it was at $37 at the height of the financial bubble).

I’ll leave you with one final, redeeming comment for the banking sector. Not all banks are like the big names such as JPMorgan, Bank of America, or CitiGroup. There are well-run banks at the regional or state level operated by good people who don’t attempt the sorts of financial trickery of the big names.

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